Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

General

W.W. Grainger, Inc. (Grainger or Company) is a broad line, business-to-business distributor of maintenance, repair and operating (MRO) products and services with operations primarily in North America, Japan and Europe. More than 3.5 million customers worldwide rely on Grainger for products such as safety, gloves, ladders, motors and janitorial supplies, along with services such as inventory management and technical support. These customers represent a broad collection of industries (see Note 2 to the Consolidated Financial Statements (Financial Statements)). They place orders through digital channels, over the phone and at local branches. Approximately 5,000 suppliers provide Grainger with about 1.6 million products stocked in Grainger's distribution centers (DCs) and branches worldwide.

Grainger’s two reportable segments are the U.S. and Canada (Acklands - Grainger, Inc. and its subsidiaries). These reportable segments reflect the results of the Company's high-touch solutions businesses in those geographies. Other businesses include the endless assortment businesses, (Zoro in the U.S. and MonotaRO in Japan), and smaller international high-touch solutions businesses in Europe and Mexico.

Outlook

The Company’s strategic priority for 2020 is clear: relentlessly expand Grainger’s leadership position in the MRO space by being the go-to-partner for people who build and run safe, sustainable and productive operations. To achieve this, each Grainger business has a set of strategic objectives focused on top line growth through market share gain. The U.S. business is focused on growing through differentiated sales and services (e.g., direct customer relationships and onsite services), advantaged MRO solutions (e.g., get customers the exact products and services they need to solve a problem quickly) and unparalleled customer service (e.g., deliver flawlessly on every customer transaction). The Canada business is focused on growing volume and gaining market share after substantially completing a multi-year turnaround. The other businesses are primarily focused on profitably growing the international high-touch businesses in Europe and Mexico and the endless assortment businesses through product assortment expansion and innovative customer acquisition. Additionally, all Grainger businesses are focused on continuously improving cost structures, investing in digital marketing, technology and supply chain infrastructure to ultimately deliver long-term returns for shareholders.

Results of Operations

The following table is included as an aid to understanding changes in Grainger's Consolidated Statements of Earnings (in millions of dollars):

	For the Years Ended December 31,
									Percent Increase/(Decrease) from Prior Year			As a Percent of Net Sales
	2019				2018				2019			2019			2018
Net sales	$	11,486			$	11,221			2	%		100.0	%		100.0	%
Cost of goods sold	7,089				6,873				3	%		61.7	%		61.3	%
Gross profit	4,397				4,348				1	%		38.3	%		38.7	%
Selling, general and administrative expenses	3,135				3,190				(2	)%		27.3	%		28.4	%
Operating earnings	1,262				1,158				9	%		11.0	%		10.3	%
Other expense, net	53				77				(31	)%		0.5	%		0.7	%
Income taxes	314				258				22	%		2.7	%		2.3	%
Net earnings	895				823				9	%		7.8	%		7.3	%
Noncontrolling interest	46				41				12	%		0.4	%		0.4	%
Net earnings attributable to W.W. Grainger, Inc.	$	849			$	782			8	%		7.4	%		7.0	%

2019 Compared to 2018

Grainger's net sales of $11,486 million for the year ended 2019 increased $265 million, or 2.5%, compared to the same period in 2018. The increase in net sales was primarily driven by volume increases in the U.S. business from market share gain and continued double-digit growth in the endless assortments businesses, partially offset by lower sales in the Canada business and other businesses. See Note 14 to the Financial Statements and refer to the Segment Analysis below for further details.

Gross profit of $4,397 million for the year ended 2019 increased $49 million, or 1% compared with the same period in 2018. The gross profit margin of 38.3% decreased 0.5 percentage points when compared to the same period in 2018, primarily driven by the lower margin endless assortment businesses which are growing at a faster rate than the rest of the Company. Elsewhere, lower gross profit margins in the U.S. were offset by supply chain favorability in Canada.

The tables below reconcile reported Selling, general and administrative expenses (SG&A), operating earnings, net earnings attributable to W.W. Grainger, Inc. and diluted earnings per share, determined in accordance with Generally Accepted Accounting Principles (GAAP) in the United States of America to adjusted SG&A, operating earnings, net earnings attributable to W.W. Grainger, Inc. and diluted earnings per share, which are all considered non-GAAP measures. The Company believes that these non-GAAP measures provide meaningful information to assist shareholders in understanding financial results and assessing prospects for future performance as they provide a better baseline for analyzing the ongoing performance of its businesses by excluding items that may not be indicative of core operating results. Because non-GAAP financial measures are not standardized, it may not be possible to compare these measures with other companies' non-GAAP measures having the same or similar names. These non-GAAP measures should not be considered in isolation or as a substitute for reported results. These non-GAAP measures reflect an additional way of viewing aspects of operations that, when viewed with GAAP results, provide a more complete understanding of the business. All tables below are in millions of dollars:

	Twelve Months Ended
	December 31,
	2019				2018			%
SG&A reported	$	3,135			$	3,190		(2	)%
Restructuring, net of branch gains (U.S.)	5				9
Restructuring, net of branch gains (Canada)	—				35
Restructuring (Other businesses)	2				5
Impairment charges (Other businesses)	120				139
Restructuring (Unallocated expense)	(1		)		(2		)
Subtotal	126				186
SG&A adjusted	$	3,009			$	3,004		—	%
	2019				2018			%
Operating earnings reported	$	1,262			$	1,158		9	%
Total restructuring, net and impairment charges	126				186
Operating earnings adjusted	$	1,388			$	1,344		3	%
	2019				2018			%
Net earnings attributable to W.W. Grainger, Inc. reported	$	849			$	782		8	%
Total restructuring, net and impairment charges	126				186
Tax effect (1)	(17		)		(16		)
Total restructuring and impairment charges, net of branch gains and tax	109				170
Net earnings attributable to W.W. Grainger, Inc. adjusted	$	958			$	952		1	%
(1) The tax impact of adjustments and non-cash impairments are calculated based on the income tax rate in each applicable jurisdiction, subject to deductibility and the Company's ability to realize the associated tax benefits.

SG&A of $3,135 million for the year ended December 31, 2019 decreased $55 million, or 2% compared to $3,190 million in the same period in 2018. In the fourth quarter of 2019, Grainger recorded $120 million of impairment charges related to intangible assets at the Cromwell business in the U.K., which is in other businesses and in the third quarter of 2018, the Company recorded $139 million of impairment charges related to goodwill and other intangible assets for Cromwell. Excluding restructuring, net and impairment charges in both periods as noted in the table above, SG&A was flat to prior year on net sales growth of 2.5%.

Operating earnings of $1,262 million in 2019 increased $104 million, or 9% compared to $1,158 million in the same period in 2018. Excluding restructuring, net and impairment charges in both periods as noted in the table above, operating earnings increased $44 million, or 3%, driven primarily by cost take-out actions in the Canadian business and improved SG&A leverage in the U.S. business.

Other expense, net of $53 million for the year ended 2019, decreased $24 million, or 31% compared to the same period in 2018. The decrease in expense was primarily due to lower losses from the conclusion of the Company's clean energy investments during the second half of 2018.

Income taxes of $314 million for the year ended 2019 increased $56 million, or 22% compared to $258 million for the same period in 2018. Grainger's effective tax rates were 26.0% and 23.9% in 2019 and 2018, respectively. The increase was primarily driven by lower tax benefit from stock-based compensation and the absence of the Company's clean energy tax benefits in 2019 as the Company concluded its investments in 2018.

Net earnings attributable to W.W. Grainger, Inc. for the year ended 2019 increased $67 million, or 8% to $849 million from $782 million in the same period in 2018. Excluding restructuring, net and impairment charges and income taxes from both periods as noted in the table above, net earnings increased $6 million, or 1%. The increase in net earnings primarily resulted from lower SG&A and other expense, net.

Diluted earnings per share was $15.32 for the year ended 2019 and increased 12% compared to $13.73 for the same period in 2018, due to higher net earnings and lower average shares outstanding. Excluding restructuring, net and impairment charges and income taxes from both periods as noted in the table above, diluted earnings per share would have been $17.29 compared to $16.70 in 2018, an increase of 4%.

2018 Compared to 2017

For the full year 2017 to 2018 comparative discussion, see Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations in Grainger’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018.

Segment Analysis - 2019 Compared to 2018

The following comments at the reportable segment and other business unit level include external and intersegment net sales and operating earnings. See Note 14 to the Financial Statements.

United States

Net sales were $8,815 million for the year ended 2019, an increase of $227 million, or 2.5% compared with net sales of $8,588 million for 2018 and consisted of the following:

	Percent Increase (Decrease)
Volume	2.0%
Price	0.5
Intersegment sales to Zoro (included in other businesses)	0.5
Other	(0.5)
Total	2.5%

Overall, revenue increases were primarily driven by market share gains. See Note 2 to the Financial Statements for information related to disaggregated revenue.

Gross profit margin decreased 0.4 percentage points compared to the same period in 2018 reflecting the impact of contract renegotiations and customer mix.

SG&A for the year ended 2019 was flat compared to the same period in 2018 due to strong expense management.

Operating earnings of $1,391 million increased $53 million, or 4% from $1,338 million in the same period of 2018. This increase was driven primarily by higher sales, higher gross profit dollars and improved SG&A leverage.

Canada

Net sales were $529 million for the year ended 2019, a decrease of $124 million, or 19% when compared with $653 million for 2018 and consisted of the following:

	Percent (Decrease)/Increase
Volume	(19.0)%
Price	2.0
Foreign Exchange	(2.0)
Total	(19.0)%

For the year ended 2019, volume decreased by 19 percentage points compared to the same period in 2018 due to customer disruption as a result of actions taken to reduce the branch footprint and optimize sales coverage.

Gross profit margin increased 0.7 percentage points in 2019 compared to the same period in 2018 primarily due to inventory and supply chain efficiencies.

SG&A decreased $89 million, or 34% in 2019 compared to the same period in 2018. Excluding restructuring, net in both periods as noted in the table above, SG&A would have decreased $54 million, or 24% compared to the prior period. This decrease was primarily due to cost reduction actions and lower variable expense as a result of lower sales volume.

Operating earnings were $3 million for the year ended 2019 compared to losses of $49 million in the same period in 2018. Excluding restructuring, net in both periods (as noted in the table above and Note 5 to the Financial Statements), operating earnings would have been $3 million compared to operating losses of $14 million in the prior period primarily due to lower SG&A and lower sales volume.

Other businesses

Net sales for other businesses were $2,651 million for the year ended 2019, an increase of $210 million, or 8.5%, when compared to the same period in 2018. The net sales increase was primarily due to incremental sales at the endless assortment businesses and consisted of the following:

	Percent Increase/ (Decrease)
Volume	9.5%
Foreign exchange	(1.0)
Total	8.5%

The net sales increase was primarily due to customer acquisition growth from the endless assortment businesses,

partially offset by foreign exchange headwinds from the euro and pound sterling.

Operating losses for other businesses were $9 million for the year ended 2019, a decrease of $17 million, or 216% compared to operating earnings of $8 million for 2018. Other businesses included impairment charges in 2019 and 2018 relating to the Cromwell business in the U.K. See Note 4 and Note 5 to the Financial Statements. Excluding restructuring, net and impairment charges in both periods, operating earnings decreased $40 million, or 27%. This decrease is primarily due to the endless assortment businesses' investments to drive long-term growth and performance in the high-touch solutions businesses.

Segment Analysis - 2018 Compared to 2017

For the full year 2017 to 2018 comparative discussion, see Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations - Segment Analysis - 2018 Compared to 2017 in Grainger’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018.

Financial Condition

For the full year 2017 discussion, see Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition in Grainger’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018.

Grainger believes that its current level of cash and cash equivalents, marketable securities and availability under its revolving credit facilities will be sufficient to meet its liquidity needs. Grainger expects to continue to invest in its business and return excess cash to shareholders through cash dividends and share repurchases, which it plans to fund through total available liquidity and cash flows generated from operations. Grainger also maintains access to capital markets and may issue debt or equity securities from time to time, which may provide an additional source of liquidity.

Cash and Cash Equivalents

At December 31, 2019 and 2018, Grainger had cash and cash equivalents of $360 million and $538 million, respectively. Approximately 69% and 49% were outside the U.S. as of December 31, 2019 and 2018, respectively. Grainger has no material limits or restrictions on its ability to use these foreign liquid assets.

Cash Flows

2019 Compared to 2018

Net cash provided by operating activities was $1,042 million and $1,057 million for the years ended December 31, 2019 and 2018, respectively. The decrease in cash provided by operating activities was primarily related to employee variable compensation payments, partially offset by favorable net income and changes in working capital.

Net cash used in investing activities was $202 million and $166 million for the years ended December 31, 2019 and 2018, respectively. This increase in net cash used in investing activities was primarily driven by lower proceeds from the sales of assets when compared to the prior year.

Net cash used in financing activities was $1,023 million and $670 million in the years ended December 31, 2019 and 2018, respectively. The increase in net cash used in financing activities was primarily driven by higher treasury stock repurchases in 2019 compared to 2018 and lower proceeds from stock options exercised.

Working Capital

Internally generated funds are the primary source of working capital and growth initiatives including capital expenditures. Grainger's working capital is not impacted by significant seasonality trends throughout the year.

Working capital consists of current assets (less non-operating cash) and current liabilities (less short-term debt, current maturities of long-term debt and lease liabilities). Working capital was $2,092 million at December 31, 2019, compared with $1,898 million at December 31, 2018, primarily due to an increase in accounts receivable and inventory and decreases in accrued compensation and benefits partially offset by increases in accounts payable. At these dates, the ratio of current assets to current liabilities was 2.6 and 2.4, respectively.

Capital Expenditures

In each of the past two years, a portion of the Company's net cash flows has been used for additions to property, buildings, equipment and capitalized software (presented in Intangibles - net on the Consolidated Balance Sheet) as summarized in the following table (in millions of dollars):

	For the Years Ended December 31,
	2019				2018
Land, buildings, structures and improvements	$	47			$	69
Furniture, fixtures, machinery and equipment	131				137
Subtotal	178				206
Capitalized software	43				33
Total	$	221			$	239

In 2019, the Company continued to invest in its North American and Japanese distribution networks (e.g. new DCs and branches as well as machinery and equipment to further automate the distribution process). In addition, the Company invested in the development of inventory management and software solutions.

In 2018, the Company continued to invest in its North American distribution network (e.g. new or expanding existing facilities and technology). Other investments include the consolidation of facility and office locations and development of software solutions.

Projected spending for 2020 is expected to be approximately $250 million which includes continued investments in its supply chain, software development, office space maintenance and inventory management solutions. Grainger expects to fund 2020 capital spending primarily from operating cash flows.

Debt

Grainger maintains a debt ratio and liquidity position that provides flexibility in funding working capital needs and long-term cash requirements. In addition to internally generated funds, Grainger has various sources of financing available, including bank borrowings under lines of credit. Total debt, which is defined as total interest-bearing debt (short-term current and long-term) and lease liabilities as a percent of total capitalization, was 54.3% and 51.5%, as of December 31, 2019 and 2018, respectively.

Grainger receives ratings from two independent credit ratings agencies: Moody's Investor Service (Moody's) and Standard & Poor's (S&P). Both credit rating agencies currently rate our corporate credit at investment grade. The following table summarizes the Company's credit ratings at December 31, 2019:

	Corporate		Senior Unsecured		Short-term
Moody's	A3		A3		P2
S&P	A+		A+		A1

Commitments and Other Contractual Obligations

At December 31, 2019 Grainger's contractual obligations, including estimated payments due by period, are as follows (in millions of dollars):

	Payments Due by Period
	Total Amounts Committed				Less than 1 Year				1 - 3 Years				3 - 5 Years				More than 5 Years
Debt obligations	$	2,181			$	246			$	129			$	6			$	1,800
Interest on debt	2,035				81				157				156				1,641
Operating lease obligations	239				63				100				46				30
Purchase obligations:
Uncompleted additions to property, buildings and equipment	88				88				—				—				—
Commitments to purchase inventory	498				498				—				—				—
Other goods and services	317				177				112				28				—
Other liabilities	103				81				5				4				13
Total	$	5,461			$	1,234			$	503			$	240			$	3,484

See Notes 6, 7 and 9 to the Financial Statements for further detail related to debt, interest on debt and operating lease obligations.

Purchase obligations are made in the normal course of business to meet operating needs. While purchase orders for both inventory purchases and non-inventory purchases are generally cancelable without penalty, certain vendor agreements provide for cancellation fees or penalties depending on the terms of the contract.

Other liabilities represent future payments for profit sharing and other employee benefit plans.

The Company's net obligation for postretirement healthcare benefits plan of approximately $2 million, is not included in the table above as no additional amounts are required to be funded as of December 31, 2019. The Company's historical practice regarding this plan has been to contribute amounts necessary to satisfy minimum pension funding requirements, plus periodic discretionary amounts determined to be appropriate.

Grainger has recorded a noncurrent liability of approximately $32 million for tax uncertainties and interest at December 31, 2019. This amount is excluded from the table above, as Grainger cannot predict the timing of these cash payments by period. See Note 13 to the Financial Statements.

Off-Balance Sheet Arrangements

Grainger does not have any material off-balance sheet arrangements.

Critical Accounting Estimates

The methods, assumptions, and estimates that used in applying the Company’s accounting policies may require the application of judgments regarding matters that are inherently uncertain. The Company considers an accounting policy to be a critical estimate if: (1) it involves assumptions that are uncertain when judgment was applied, and (2) changes in the estimate assumptions, or selection of a different estimate methodology could have a significant impact on Grainger’s consolidated financial position and results. While the Company believes that estimates, assumptions, and judgments used are reasonable, they are based on information available when the estimate was made. See Note 1 to the Financial Statements for further information on the Company’s critical accounting estimates, which are as follows:

Inventory: Inventory reflected at the lower of cost or net realizable value considering future demand, market conditions and liquidation values;

Goodwill and Intangible Assets Impairment: the valuation methods and assumptions used in assessing the impairment of goodwill and intangible assets; and

Contingencies*:* the estimation of when a contingent loss is probable and reasonably estimable.

Forward-Looking Statements

From time to time, in this Annual Report on Form 10-K, as well as in other written reports, communications and verbal statements, Grainger makes forward-looking statements that are not historical in nature but concern forecasts of future results, business plans, analyses, prospects, strategies, objectives and other matters that may be deemed to be “forward-looking statements” under the federal securities laws. Forward-looking statements can generally be identified by their use of terms such as “anticipate,” “estimate,” “believe,” “expect,” “could,” “forecast,” “may,” “intend,” “plan,” “predict,” “project,” “will” or “would” and similar terms and phrases, including references to assumptions.

Grainger cannot guarantee that any forward-looking statement will be realized and achievement of future results is subject to risks and uncertainties, many of which are beyond the Company's control, which could cause Grainger's results to differ materially from those that are presented.

Important factors that could cause actual results to differ materially from those presented or implied in the forward-looking statements include, without limitation: higher product costs or other expenses; a major loss of customers; loss or disruption of sources of supply; increased competitive pricing pressures; failure to develop or implement new technology initiatives or business strategies; failure to adequately protect intellectual property or successfully defend against infringement claims; fluctuations or declines in the Company's gross profit percentage; the Company's responses to market pressures; the outcome of pending and future litigation or governmental or regulatory proceedings, including with respect to wage and hour, anti-bribery and corruption, environmental, advertising, product liability, safety or compliance, or privacy and cybersecurity matters; investigations, inquiries, audits and changes in laws and regulations; failure to comply with laws, regulations and standards; government contract matters; disruption of information technology or data security systems involving us or third parties on which we depend; general industry, economic, market or political conditions; general global economic conditions including tariffs and trade issues and policies; currency exchange rate fluctuations; market volatility, including volatility or price declines of the Company's common stock; commodity price volatility; labor shortages; facilities disruptions or shutdowns; higher fuel costs or disruptions in transportation services; pandemic diseases or viral contagions; natural and other catastrophes; unanticipated and/or extreme weather conditions; loss of key members of management; the Company's ability to operate, integrate and leverage acquired businesses; changes in effective tax rates; changes in credit ratings or outlook; the Company's incurrence of indebtedness and other factors identified under Item 1A: Risk Factors and elsewhere in this Form 10-K.

Caution should be taken not to place undue reliance on Grainger's forward-looking statements and Grainger undertakes no obligation to update or revise any of its forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.